Breakdown of Covered Interest Parity: Mystery or Myth?

22 Pages Posted: 6 Apr 2018

See all articles by Alfred Wong

Alfred Wong

Hong Kong Monetary Authority

Jiayue Zhang

Hong Kong Monetary Authority

Multiple version iconThere are 3 versions of this paper

Date Written: March 2018

Abstract

The emergence and persistence of basis spreads in cross-currency basis swaps (CCBS) since the global financial crisis have become a mystery in international finance, as they violate the long-standing principle of covered interest parity (CIP). We argue that the phenomenon is no mystery but merely a reflection of the different risks involved between money market and CCBS transactions in the post-crisis era. Empirical results based on seven major currency pairs support our hypothesis that swap dealers behave as if they seek to align the risks of the transactions in pricing CCBS, which causes CIP to break down. We also find that the basis spreads are well arbitraged among the currency pairs, which suggests they are fairly priced. Hence, it is a myth that CCBS basis spreads or CIP deviations are evidence of the market not functioning properly.

Full Publication: The Price, Real and Financial Effects of Exchange Rates

Keywords: covered interest parity, FX swap, cross-currency basis swap, basis spread, CIP deviation, Libor-OIS spread, counterparty credit risk, funding liquidity risk

JEL Classification: F31, F32, G15

Suggested Citation

Wong, Alfred and Zhang, Jiayue, Breakdown of Covered Interest Parity: Mystery or Myth? (March 2018). BIS Paper No. 96d. Available at SSRN: https://ssrn.com/abstract=3154028

Alfred Wong (Contact Author)

Hong Kong Monetary Authority ( email )

3 Garden Road, 30th Floor
Hong Kong
Hong Kong

Jiayue Zhang

Hong Kong Monetary Authority ( email )

3 Garden Road, 30th Floor
Hong Kong
Hong Kong

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